Energy Markets and Musical Chairs

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Ten years ago, we thought the world was running out of oil, that China and other emerging market countries would have insatiable energy demand growth, and that production costs would generally rise over time.

What’s changed? Jaffe said the peak oil theory was just plain wrong. On the supply side, technology is driving efficiency gains that are transforming the entire energy landscape. In fact, Jaffe referred to it as the Fourth Industrial Revolution. The economics of shale oil are driving costs lower and lower. Natural gas costs have fallen below $1 per 1,000 cubic feet (mcf) and will make US-based natural gas competitive in liquefied natural gas markets globally. Recently, innovations in solar and power storage technologies have driven solar costs below comparable natural gas solutions.

On the demand side, tech innovation is spurring revolutions in resource management, transportation, and logistics, among other areas. Moreover, policy changes related to pollution, mandated fuel efficiency standards, and climate change are increasingly being implemented by governments around the world, promising to curb demand further.

Ten years ago, China emerged onto the world stage as a large and perennial powerhouse, growing at more than 10% per year. Demand from China alone for many commodities rose to an eye-popping 40%, 50%, and 60% in a number of commodity markets. The idea that many of China’s 1.3 billion people would soon be converting to gas-guzzling cars, trucks, and industrial equipment was burned into the minds of many investors.

Now, in 2016, China is struggling to swallow some $7 trillion in misallocated capital. The explosion of debt that fueled its meteoric rise is now coming due and will likely weigh on its economy for some time. China is also approaching energy from a policy perspective, pushing laws and regulations to curb emissions. And the Chinese people are embracing new technologies, like ride-hailing apps, not just as modes of transportation, but as ways to meet people. So, consumption patterns are changing too.

Lastly, many players in the energy industry used to embrace the notion that the real value of a barrel of oil would increase over time. So, reserves in the ground would be more valuable simply by leaving them alone. For example, in countries like Saudi Arabia, there was an incentive to sit on reserves and only access them slowly over time. Now, that proposition has been turned on its ear.

Jaffe commented that recent solar and power-storage innovations promise to deliver energy at a lower cost than that of a comparable amount of natural gas. With very real competition from the wave of alternative energy innovations, changes in consumption patterns, efficiency gains, and the increasingly bold impact of policy, the game has changed.

And like in a game of musical chairs, many countries are now increasingly concerned about stranded assets — about being left without a seat. What does oil project ROI look like in a declining oil world? If the real price of oil drifts downward rather than upward over time, players in the energy industry have an incentive to maximize production today to extract maximum value.

Jaffe concluded her talk with a personal anecdote. She currently drives a hybrid vehicle that employs a host of sensors tracking how much the vehicle switches between gasoline to electric power. About 65% of her miles driven are powered by electric only. Of course, such vehicles still require energy production from power plants, but very few of them run on oil.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Amy Myers Jaffe, executive director for energy and sustainability at the University of California, discusses how investors will view oil and gas funds on a forward-looking basis if oil prices start to recover. Increasingly, scenario analysis by top financial institutions and oil companies is starting to acknowledge the possibility of a peak in global oil demand growth: What would global peak oil demand look like, and what impact would it have on energy companies’ performance and strategy; Do investors need to worry about “stranded” coal, oil, and gas reserves as part of their risk management, and if so, in what time horizon?

Stephen J. Brown: Last May, I attended a meeting in London organized by the Prince of Wales’ Accounting for Sustainability project — I, along with editors of the leading journals of accounting and finance. At this meeting in his prepared remarks, the prince made a particular point of emphasizing the important role that CFA Institute has to play on these sustainability issues. This issue has important practice relevance.

As I explain in the editorial that I have coming out in the next issue of the Financial Analysts Journal, we need to develop portfolio strategies that address both the threats and opportunities that arise in this context. It’s my great pleasure to introduce to you Amy Myers Jaffe, who will be speaking on some of these issues. Amy is the executive director for energy and sustainability at the University of California, Davis.

She’s also chair of the World Economic Forum, Davos, Global Agenda Council on the Future of Oil & Gas. She is recognized as a leading authority in this field, has published extensively both academically and in New York Times, Dow Jones International, Petroleum Intelligence Weekly, and many other fora. Please welcome Amy Myers Jaffe. Thank you.

[APPLAUSE]

Amy Myers Jaffe: Thank you, Stephen. It’s really a pleasure to be here this morning on a very important topic. I am very honored to be here to address the CFA Institute in this very critical year in the energy world. And I want to begin my remarks by sort of setting the context. Oftentimes, I go to do public speaking and the first thing on everybody’s mind is, where does she think the price of oil is going to go?

And I’ll definitely address that over the course of the talk. But I really want to talk a little bit about, what is the structural change that we’re seeing across the energy industry, and what is part of just the short-term commodity cycle? And I find that when people commentate on both of those things, you’re getting some conflation of issues, and that’s confusing people. So the goal of my talk today is to really leave you with a clearer idea of what are short-term factors — geopolitics, oil and gas supply, falling costs of renewables — and what is the long-term picture? Do we have to worry about stranded assets?

If we do, how is that going to come into the market? How do I make investment decisions? And I agree with the theme of the last panel, which is that the way we’ve all viewed this industry, especially in energy over the last 30 years, is not going to help us analyze the next 20 years. And I want to talk to you a little bit today about why.

The World Economic Forum has coined a term which is the theme for this year called “the fourth Industrial Revolution.” And people refer to it in different ways. Stanford refers to it as the “resource revolution.” You have other players that discuss it and talk about the “industrial Internet.”

But the bottom line is, we’re having exponential gains in productivity. And those gains come from everything from transportational logistics, which we all understand if anybody took a ride-sharing service from the airport here to the convention. It can be automation. What do we think is going to happen in robotics? Big data is absolutely revolutionizing everything from medicine to logistics to energy management.

And so when we look at the things, we understand that not only is the way we consume and use energy, or the way that resources can be exploited and developed and at what cost, but that we’re really having a decoupling of energy growth and economic growth and energy use.

So the story that you’ve heard for the last decade or more about why energy prices were going to stay high exponentially forever was, the growing middle classes of the developing world were going to want to live in the same lifestyle as being enjoyed in the West, and that that’s not possible to do without tremendous pressure on energy, infrastructure, and resources. And some of those pressures are alive and well.

But on the other hand, we’re going to be able to do those same things with a lot less fuel. And understanding how much, what’s the level of change, and what’s possible, is really what people are struggling with now in thinking about the long term versus the short term. But really, across the entire energy chain, there’s just dramatic change.

And you’re seeing that in private equity space. So is it the economics of shale, for those investors who invested in new MLPs or oil and gas, whether that’s midstream pipelines or on the upstream. First you had the price collapse. That seemed really like a crisis. But then, depending on what venture you were in, maybe the profit level really was able to be sustained to some extent because the costs have so fallen.

And I would expect the costs to fall more. As people apply more and more technology to drilling, we’re seeing things like natural gas being able to be produced under $1 per Mcf in the United States that could be exported and be competitive with Middle East LNG.

So it’s really a changed market. And it’s everything. Utility-scale solar is being contracted for on a long-term basis at prices that are lower than natural gas. And we have this whole question about, how will mobility services affect long-term oil demand for fuel? You can look at energy efficiency in terms of advanced automobiles.

Somebody told me a story recently about new program that General Electric has. If you’re an airline, you’ve been using their jet engines — they can take and show you how to take the big data of weather patterns on any given day across the world and tell you which planes to deploy on which routes based on saving fuel. And you’re getting entities saving 10%, 15% jet fuel than past operations, just 100% based on big data analytics.

So really, it’s a changed market. And the presumption that demand profile is going to look the same as it has over the last 20 years is incorrect. And so, how do we go back and understand the markets in that context? In terms of competitive landscape, we’re seeing that the oil majors that also used to dominate in the space are no longer going to dominate the space.

We see tech companies — Apple, Google — coming into the space with new technologies and new kind of products that are going to revolutionize the way people think about and use energy. And we’re seeing a much more direct role in the markets for private equity and institutional investors. It used to be that the majors were the majors because in the end, the only people with the scaled capital that could invest in something like onshore oil and gas were the majors. But today, the majors are competing with money from Wall Street. They’re competing for money from institutional investors.

And if something has a return of 7%, if it’s got steady cash flow, that might be a good investment for an institutional investor. For ExxonMobil, they were looking for 17% return on capital. How are they going to compete in a market where there’s billions of dollars that will come in at 7%? So it really completely changes the competitive framework for the market.

Now, let’s talk about oil and gas prices, because that’s the elephant in the room. So in the past, when prices were $100 and everybody thought it would stay there and then eventually escalate to $200, and people talked about how many Chinese were going to have a car, and we’re running out of assets — there were three things driving that market that created a giant psychological exuberance for investing in oil and gas, that are basically over.

We know that peak oil theory truly is incorrect, because we can see that now the oil industry has developed technologies where, instead of having to search for a pocket of oil or reservoir of oil deep under the ground using seismic and other technology and having some failures, the industry has now basically figured out how to take microscopic particles of oil and gas that’s pressed into basically solid rock and come up with an operating system to retrieve those tiny particles into a flowable oil and gas drain.

And when people to talk about shale and they say, “Well, you know, Amy, eventually the shale is going to get worked out in the United States and then it’s never going to spread internationally,” you can’t think about it that way. It’s a revolutionary technological way to produce oil and gas from known resources in the ground. You have to think about it like manufacturing.

Anyplace that there was source rock, which means any place that’s ever produced oil and gas ever in history, which is why we have so much production now coming out of Pennsylvania — anyplace that has source rock, eventually the industry will be able to build a technology to retrieve it. Right now, they have a good technology for shale. But eventually, with more research, it might be in other kinds of rocks. So you really have to understand that this is game-changing in a way that I don’t think people have fully understood.

The second thing which we can all really see is that it’s not a given that China’s economy is going to grow at 10% a year. And it’s not a given that China is going to do everything with oil and gas and fossil fuels, even coal. The government has made a commitment to clean energy. They were an active party at COP21, the climate accords.

So the landscape for China could be radically different. You have people who are senior people in the oil and gas industry in China that are talking about the possibility that diesel demand in China has already peaked and that gasoline demand itself might peak in the 2020s. So you’re really talking about a changed picture to the whole China story.

And then there was another story that people like to tell you why oil prices can’t go below $70 and stay there, and that was this rising cost. It’s so expensive to explore for oil. We need $70 to do the oil sands in Canada. We need $70 for what we call the marginal barrel, like that last 10% of oil that has to be produced is so expensive.

But the lesson of the shale industry, and even in deep water, which I think we’re going to see more automation. We just had the Offshore Technology Conference last week in Houston. People were talking about using artificial intelligence and robotics to reduce the costs dramatically and reduce the number of people, quite frankly, that are going to be employed in a very dangerous industry. So the bottom line is, costs are not going to be the thing holding up the price of oil, truly. Because technology is going to be lowering those slowly over time.

So where does that leave us? We’ve got productivity also in the shale. So again, changing the competitive outlook. And the question is going to be as these costs go down, it’s going to vary from location to location. And so institutional investors — the lucky thing for institutional investors is from about 2003 to 2011, you could basically just throw a dart and you’d make some money investing in shale. Right?

Well, that’s not going to be true anymore. Now you’re going to actually have to know what you’re doing. You’re going to have to know what locations could be productive; what locations, what operators are going to be able to keep their costs low. It’s going to be a competitive environment. And so you’re going to need more knowledge to be able to invest in this space.

But the bottom line is in thinking in a very broad way about, where are people picking the prices that you see now? Why is Wall Street predicting the kind of prices that they’ve been predicting — $35 and $45? It kind of seems like they’re just picking at out of the air, because if I’m saying that the whole cost structure for producing oil and gas is changing and the technology is changing, how are people even picking out a price?

And I postulate to you that ultimately, what do we do in oil and gas when we have to think about prices? We go back to history. So if you adjust for inflation, basically the oil price has gone back to its historical mean. And today because of the crisis in Canada with the fires and some other geopolitical factors in the Middle East, I would say roughly, on an average basis — so let me show you the chart.

On a real basis, the price of oil hovers around $35 a barrel. So if you think about the markets in the couple of years, the last bunch of years, whether we’ve had a $10 tariff premium or $10 some kind of a supply risk premium, the $35 or $45 range is in line with the actual historical average for oil and gas on a real basis. And you can see, as I mentioned, this period that we just experienced where prices were $100 or $90, this was an aberration to what has really been a long-term historical trend that currently the current prices are in line with.

So am I saying that, “Oh, well, we’re never going to get back above $45. This is the permanent price; $35 is the permanent price”? No, I’m not saying that. Obviously, the view on Wall Street is that we’re going to creep up a little bit. But they’re just basically saying maybe $50, maybe $60, because markets will tighten up over time as demand in the economy recovers. We get some delays or cancelations in exploration.

But ultimately, what I want to have you understand is that it’s two different things. The long-term trend, which is structural, has to do with technology. And it’s going to eliminate demand at the same time it lowers the cost for replacing energy supply, whether that’s clean energy supply or fossil energy supply. And so in the end, the long-term trend is not really going to be, in my opinion, very inflationary.

The problem is in that interim period — two years, three years — there are so many things that can go wrong: whether that’s weather-related disasters like we’re seeing today in Canada; whether that’s an offshore accident; whether that’s the geopolitics between Saudi Arabia, Iran, and Russia. There are other reasons why the price of oil could go back up for some period of time, even though we’re having a structural change in the cost structure and probably perceptions about where the long-term commodity is going to go.

So I try to remind people, truly, four times over the course of my lifetime as an oil and gas analyst I have seen prices go up and down. Prices go down like they are today in the bust cycle. That creates pressure on all the governments that are oil-dependent, oil revenue–dependent — Venezuela, Russia, Saudi Arabia, Nigeria. Oftentimes, when that pressure becomes intense, you see more violence, civil unrest. That causes a supply disruption, and we go right back into the cycle.

So you really need to stay with a keen understanding that just because we can see the technology and the structural changes coming, we can understand, with climate change and the regulations that are going to come with climate change, that we’re going to have a structural shift in the value of assets over time.

It doesn’t mean that in some short-term way, we couldn’t see another spike in the price of oil. And I think that’s really what confuses people. It’s like, are we in a cycle so we’re in a downturn and we’re going to go back to an upturn? Or are we in a structural decline? And really, what I would tell you is, it’s both; all of the above — which is not the most enlightening answer, but that is really what we’re going to see. We’re going to see still volatility in the commodity, but volatility off of a declining asset value.

So what does that mean? Well, if there isn’t a major supply disruption in the short term, there are an awful lot of companies that are facing a debt wall that’s going to be hard to service. And that has to do with the fact that when banks provided revolving loans, especially to US-based companies that were drilling in shale oil and gas, it was based on the company’s capitalization. Well, the company’s capitalizations have fallen dramatically because of the repricing of the reserves and what the market expects the price of oil gas to be in the short run. And so therefore, there’s a lot of pressure on the industry, and pressure on investments that are holding stakes in those companies or in the funds that invested.

And there’s going to be pressure on banks, and not every bank is equal. You can look at the percentage of energy loans that are in the smaller regional banks. And some of them are more than others, those banks are going to be under pressure for their own capital balance sheet. And then you have on the international stage, you’ve got a bank like Société Général, which again has a very high energy loaning portfolio. And that may be a more strainful capital position going forward.

How does the structural changes, whether that’s the long-term changes, impact investors now? When you think about, what do I do as an investor, first of all you have to think about, what’s your time horizon? Are you looking to make an investment for a three-year time frame? Or are you an institutional investor, and you have patient capital, and you’re looking to hold an asset for a long time? And that’s where the change that’s coming in the industry is really dramatic and really needs to be thought about thoughtfully.

So here’s really what’s happened. For 30 years, truly, 30 years, people have been saying the price of oil is going to go up over time. And what people really believed for 30 years was that an asset held under the ground, a reserve held under the ground, would be more valuable in the future than it was in the present. And that completely influenced the way companies did business and the way countries did business.

The view was, if I hold this asset long enough, I warehouse it. I warehouse acreage. I will eventually be at a producer and make more money. And so there was a belief that reserves would eventually deplete. Those left holding reserves — that would be Saudi Arabia or Russia, ExxonMobil, whoever had big balance sheets or big positions as a state institutional player — would be sitting pretty after 2010.

Because then the so-called easy oil — Alaska would be in decline. The UK North Sea would be in decline. Canada was projected to run out of natural gas. People were talking about whether there was going to be enough natural gas to produce the oil sands. These things that people predicted had a strategy that went with it.

If you were a major oil company, your strategy was honestly not much of a strategy. The strategy was, we’re going to take as much capital as we can. We’re going to book as many reserves as we can. And then we’ll have this on our balance sheet. And so as oil becomes more scarce, we’ll be a more valuable company for having these things on our balance sheet.

But if you step back from that and you say, “Well, maybe future reserves are not going to be scarce, if we can really produce oil and gas from source rock, and it’s really pretty widely available” — it’s still expensive to do but costs are falling. Some people are able to do this for breakevens in the United States on oil with $30 a barrel, $25 a barrel and some really productive assets, and in natural gas, under $1. Then maybe, just maybe, reserves under the ground might be less valuable in the future.

And if you especially believe that there is going to be an increasingly effective global climate change policy, or at least in major countries — the United States, China, India, Europe, Canada — if you believe that, then you have to start thinking about, as a company and as an investor, how many reserves do I really want to hold over what time frame?

Do I want to hold them — 10-year window good? Thirty-year window not? You have to really think it through. You have to really think now; you just can’t blithely say, “These resources are going to be more valuable in 30 years, so I want to hold them forever.”

And that’s going to change everything. And the more we see weather-related crises — major hurricanes, storms, wildfires and so forth — the more we’re going to understand that some assets are going to be harder to produce than others, or some downstream assets are going to be harder to maintain than others.

The entire petrochemical complex of the globe is in coastal cities and coastal areas. Some of those are going to be storm hit. And so really, the industry has been pretty slow to respond and react, truly. And now we as investors and those who are analysts are going to have to rethink a lot of the ways we view this whole complex.

So where do we go from here? The first thing that happens is, now we have uncertainty about demand. I talked a little bit about all the different technologies that are coming. I was speaking in Boston last week, and it was myself — I was on a panel with a young woman who manages Uber’s marketing businesses in China. She was fascinating. She told the audience that really believes in the whole “Everybody in China is going to own a car” — she said that young people in China use the carpooling service in China, not just because there’s so much congestion and really truly it’s better to use carpooling, but as a social thing, the way young people in the United States or Canada might use Facebook to make social plans in the evening or use Tinder or some of these programs to meet new people. People in China carpool to meet new people.

She told the story about a young man who drives a Ferrari for Uber. And he’s obviously not doing it for the $4 a trip. He’s doing it to meet women. So I won’t name names. When an oil company stands up and tells its shareholders that it’s certain about demand for China, they’re not counting on everybody who’s a millennial in China riding around in different cars and a van because they want to meet people.

And she had the graphic, which she showed to the group — I wish I could get it so I can share it with you all of you — that showed how much less traffic there was because so many young people in China are using Uber. Well, that adds up. So now, oil companies and agencies like the International Energy Agency are trying to do, and doing, new scenarios to look at what oil demand might look, or look like by 2040.

And in the past, people would have told you that there was no way to construct a scenario where oil demand would fall. Well, now people are starting to be able to come up with a somewhat realistic scenario about how to make oil demand fall. And we at UC Davis took the International Energy Agency’s model, which is a very sophisticated model, and we tried to undo or override certain things about having people use ride sharing or adding new technologies, having more people buy electric cars and so forth, just to see the parameters.

And what we did find is that in the short run, over the next 15 years, it was pretty easy to stagnate oil demand, actually. But then going forward to 2040, population impact kicks in, and so therefore, probably technology won’t do it alone. Probably there’s going to probably have to be some kind of a policy framework if governments and countries want to really peak demand.

But the will seems to be there, and so you really have to consider that the long-term outlook for oil demand is uncertain. And once I say it’s uncertain, then it has implications. And one of the implications is for OPEC. So when you’re playing — I don’t know how many of you know the American game of musical chairs. The game of musical chairs is, the music’s playing and we’re all going to go, and the music stops, suddenly you have to rush and get a chair.

So the oil and gas industry was playing that game. Every round they were adding a chair. Because demand was growing. We’re adding a chair. Music stops, you never have to worry about whether you’re going to get a chair or not. Well, all of a sudden, we might be going into a game where we’re going to start taking chairs out. And the music’s going to stop, and not everybody’s going to get a chair.

So people actually have to have a strategy. You have to actually have a strategy. And you have to think about the North American shale producers as guys who are carrying a foldable lawn chair on their back. They can put that chair down any time when the music stops that they like the price of oil. They can put the chair down. They can produce in six months.

So if you’re Saudi Arabia, this is a pretty serious problem. On top of that, you were already engaged in a price war that in my opinion had geopolitical dimensions. You were targeting your rivalry with Iran. You wanted certain outcomes in Syria. You weren’t having Russia cooperate in terms of working or not working with Iran, whether it’s in regional wars or whether it had to do with the nuclear deal was being negotiated with the United States.

And I will tell you, I wrote a paper in 2009 about the Saudi–Russian rivalry and the geopolitical stage. And I got some input at that time from people who were still in leadership in Saudi Arabia. And people said, “Well, if the Russians don’t focus in on what we’re saying, we’ll make a price war.” They said that in 2009. So I take it seriously now when you see these negotiations around the outcomes in Syria.

Saudi Arabia has inventory, well-placed inventory, in Asia, in storage tanks in floating ships outside Fujairah. If they stand up and tell the Russians that the Russians need to focus in, that they don’t like the way the Syrian peace negotiations are going or something else, they could make the price of oil — they could try to make the price of oil go even lower than it is today, because they have inventory. And the Russians know that.

So that’s the context in which you have these freeze discussions. And Russia and Iran have shown that they can escalate military conflict, whether it’s in Yemen or other places, and temporarily get the price of oil up for a period of time. So you have a very volatile environment. But that volatile environment is the short-term picture.

The long-term picture is, if what I’m saying is correct, which I believe it is, because it doesn’t have to be that demand gets eliminated over time. We just have to think it’s a possibility. But I have to change my strategy. Now it’s a game of survival. If I’m Saudi Arabia, does it make sense for me to cut my production so that some other player — ExxonMobil or Shell or BP — can produce all of their reserves under the ground, then mine are the ones that get stranded?

No, that doesn’t make sense. So that’s the context. When I hear people talking about, we’re going to make a freeze agreement, maybe people are really talking about, not are we going to make a freeze for six months and it’s going to look like 1998 and the price of oil can go back up, because we’re to get rid of inventory. We’re talking about making a freeze at a level that we can all agree on for the next 20 years. How much market share is enough for me so that my reserves don’t get stranded versus your reserves don’t get stranded? We’re talking about a much more complicated, competitive landscape, even just in oil and gas.

And then, if the Chinese are right and other analysts are right and products demand — even ExxonMobil, in its latest energy outlook survey to 2040, they have gasoline demand peaking, not only in the industrialized countries but worldwide in their time frame of 2040. So if that’s the case, if that’s everybody’s view, it’s China’s view.

It’s people who do a lot of very thoughtful strategic planning. Then when ConocoPhillips sold their downstream a few years ago, was that that Jim Mulva was a genius because he got his assets sold at a very high price before people realized that those assets were going to decline in value over time? Or did he really just want to expose his stock to the volatility of the commodity price?

So if you’re another company that has large refining assets today, the question is, how’s too long to hold them? Do I want to hold them forever? Do I want to sell them now? If I sell them now, will that disadvantage me, or would it be even worse in 20 years? And then we have this problem. For us, it’s the market, which is, I’m an investor. I’m holding shares in all of these assets. I’m holding direct investments in some of these assets.

If there’s no climate legislation that’s clear in the United States, if we don’t have a carbon price in the United States, if we don’t have a carbon price that functions in Europe and Asia or globally — how do I make those evaluations about how these assets are going to be evaluated in the future, and how is the market going to decide where the risk is? It could get pretty disorderly. So the Saudis have announced that markets are efficient, and they’re not holding up the market for high-cost barrels anymore.

Then, the deputy crown prince, who’s becoming a very important policymaker in Saudi Arabia and is signaling his peers in the millennial generation in Saudi Arabia that they can have a different future, that he could lead a different future, that he could succeed and eventually become king because he has the vision of his generation. He declared an end of oil. He said he’s, to position his country, the largest reserves in the world, he wants to position his country to have been income already monetized into some other asset for future generations.

Well, why would we all hold those assets? If Saudi Arabia doesn’t want to hold oil assets, why would any of us want to buy it from them? So it’s a very confusing and uncertain picture for when you want to own this commodity in terms of the base reserves and how long you want to own them. Even Saudi Arabia is confused.

So how do we view that, then, in terms of risk management and taking into account what we call the science of unburnable carbon? So the first question I always ask as a professor is, “Has anybody figured that out yet? Have the markets already reacted?” Because you know what? In the end, we all have combustion engine cars.

Actually, the truth is, I have a plug-in. But the rest of you have combustion engine cars. So the point is, you’re an incredibly intelligent, well-informed group. How long do you think it’s going to be before you buy a car that doesn’t run on gasoline? Is it going to be you? Is it going to be your children? Is it going to your children’s children? That’s a pretty hard question. And when the International Energy Agency goes through these aggressive climate accord modeling, they don’t eliminate use of oil and gas, even in the 2040 time frame.

So it’s a pretty complicated question, frankly. And we did a study where we looked at 2009, which is when the actual first scientists wrote about the stranded assets problem. And the interesting thing was, the US stock market reacted to that science. And they de-capitalized about 2 and 1/2% of the market cap of the 63 largest oil companies in the United States.

We corrected for, was the market down because of somebody’s shareholders, share announcements, or the price of oil at that time. So it shows you that the market thought there was something to it, that the market thought about how, not in a crisis kind of way, but actually had some cognizance of the fact that if the picture for oil demand were to change, that actually the valuation of reserves would change.

And now we have this problem that we have seen this year, where the market’s dramatically reacting to the fate of companies in the coal industry in the United States and elsewhere that didn’t seem to be properly responding to the risks. And I got it. Coal is greatly disadvantaged right now in the United States and elsewhere because of the low price of natural gas.

But price of natural gas has been low for a decade. And what we as investors have to think about is, which management is able to respond to the challenges that I’m telling you about? Who is walking around the chairs with no strategy, just thinking a chair’s going to be there? Because that’s not a company worth holding. This is a company that destroyed shareholder value.

And I’m not saying that every company that’s in fossil fuels is going to destroy shareholder value, because management can take different positions now. They can come up with new strategies. But we definitely don’t want to be owning the shares of a company that can’t do that.

And if you look at what happened to the coal mining stocks versus the general index, funds that said “I’m not going to look at this issue. I don’t believe in ESG. I have a fiduciary duty. I don’t do ESG.”

I mean, how did that make sense when these coal companies went bankrupt and you didn’t get out of it because you didn’t want to show that you’re responding to activists? That doesn’t make sense. You have to analyze it. You have to analyze, what are the structural trends and is the stock overvalued or not, given what’s coming for the future for these companies?

So what about renewables? Should we be hedging? Is it a good strategy for investors to, as a hedge against these kinds of risks that I’m talking about with the fossil fuel industry? It’s in your index or in your portfolio in some way. Should you be taking a proactive bet on renewables?

Well, people say, “Well, price of natural gas is so low. Renewables can’t compete.” Well, guess what? The price of solar has dropped the same amount or more. And indeed, if you look at the levelized cost for solar, it’s pretty damn competitive compared to natural gas.

So I see renewables as also competing very strongly in the space. That’s part of what happened to coal. People were unpositioned. People did not understand how the market’s changing. And that’s on top of the fact that renewables are desirable to what’s going to be the new generation.

So one of the things that people always said about baby boomers like myself is that we’re just too lazy to figure out where our electricity is coming from, and giving me a meter is not going to do anything, and so on and so forth. And universities tested that and found that to be the case. But what about all these young people who do everything on their phone?

Maybe they’re going to turn off all their appliances with their phone. And then they’re going to turn on their washing machine with their phone when electricity prices are cheap. I mean, they’re crazy. They probably do that. And I have to tell you something about the increased role of the consumer. I have this little slogan I shared with Al Gore. I called it the democratization of energy. Like, we’re going to be able to pick.

And I’ll tell you about my car. I want to finish my talk by telling you something about my car. So I’m here visiting with you. I have a certain role as a public figure in the following way. The media is doing a story about gasoline prices or the media is doing a story about energy. And they say, “Oh, Mrs. Jaffe, can we come film you in your car?”

So I have to have a car that reflects my views. So I want to tell you what I drive. I drive the Ford C-Max. Many of you probably don’t know that car. People made fun of me at UC Davis because we have all these electric charging stations in northern California. So I have a wussy solution, because I have a daughter in San Francisco. It takes an hour to get to her. I have to have a car that can get all the way to San Francisco, and I’m not wealthy enough to have a Tesla.

So this is what my car is. At the front left of my car, I have an electric battery that can go 20 miles. And then the rest of the car’s a regular Ford car. I could have gotten it in a regular-sized sedan. I chose to get the car that looks like a Prius so everybody would know I have an environmentally friendly car.

So here’s my story. They didn’t believe me at Davis. Davis is the premier place in the United States if you’re a company and you want to know how people use their electric cars. They have all these little things they put in your car. And you can’t lie on a survey and say you drive on electricity if you don’t, because they put a thing in your car.

So they put the thing in my car, and they say, “Amy is always saying she drives on electricity, but that’s all bullshit. She’s using the gasoline engine.” So they put the thing on my car, and this is a true story. You can call Tom Turrentine, who is our expert. I was driving, 65% of my vehicle miles traveled was electric, with a 20-mile battery. And there’s an insight in that.

Because even my husband, who drives a regular car, uses my car whenever it’s in the driveway, because he likes the idea that he’s beating the system. And plus, we’re kind of competitive. No one wants to be the one to have to go to the gasoline station. So if you keep plugging in the car, you can make one more trip without having to be the one to fill up the tank.

So the bottom line is, if you think about it, this little battery, it’s like getting a back windshield wiper or having the kick thing to open your thing when you have the groceries. It’s like an option. And people made fun of it, but if everyone in the United States, if the 350 million cars in the United States all had that 20 mile battery and people realized — women especially, because we all hate going to the gasoline station.

If you realized that you could do all your driving except when you’re taking a long trip on the battery by plugging it into your house, and you never have to go to the station and it’s environmentally friendly, especially if you live someplace where some of your electricity is coming from renewables, this is brilliant. It’s literally like your phone. You just plug it in when you need to. Every time you take a trip, you plug it in when you come home.

I always have battery electricity. I don’t have any range anxiety. That battery is going to go on many cars. And if everybody uses it and they eliminate even 50% of their gasoline use, that is going to have dramatic impact on the refining industry. And it’s going to lower emissions tremendously as we transition the electricity system to renewables.

So I leave you with that thought in understanding that with all the modeling and all the things that people do that show that it’s hard to eliminate oil demand, you have these technologies which, like our phones, if they were to catch on — who would have thought that maybe it wasn’t a good investment to invest in the taxi industry in someplace like New York or San Francisco? I mean, people are stuck all the time. Now you just push the button on your phone.

Who would have imagined that? Ten years ago, none of you would have imagined that. So that’s what I’m telling you about transportation. It’s in mobility. Services is what we’re really going to start purchasing. We’re going to start purchasing the ability to get from point A to point B. And we’re going to have a computer system in our pocket to help us do that.

And so understanding how that’s going to affect the long-term valuation of companies that sell liquid fuel, it’s important to think about pretty quickly. And therefore, as investors, it’s important to become more knowledgeable about the energy space and how it’s going to move, whether the pace is 10 years, 20 years, 30 years, to understand how to position yourselves to make the best of your investments. Thank you very much.

[APPLAUSE]

Stephen J. Brown: Thank you very much, Amy; this is really interesting. And I have a number of questions from the audience. And as you spoke, more and more of the questions were answered, as I’ve been told.

I have one question. You talked about the collapse of OPEC and the recent actions by the Saudi government and transferring the shareholdings to the — it seems to show that the oil producers themselves recognize that they should take market share before their reserves become stranded assets. You suggested that even they recognize that there’s a problem here. For us as investors, does that mean that the stranded asset risk is already priced in?

Amy Myers Jaffe: That’s a very good question. Probably takes some kind of methodological study. What I would say is, I believe that maybe people felt that there was — it wouldn’t be correct to say that there is no change in valuation based on this risk. I do think, to some extent, as our research has shown, but probably some more research will show over time, obviously some of it’s priced in.

And there’s still uncertainty. That’s why I mentioned to people, this idea of just blanket divesting, does that really make sense? Because management can make changes to their strategies. So Saudi Arabia has a policy right now. But we’ve seen the country of Libya implode and lose all their oil production. Literally all of their exports come off the market.

So there’s so much political risk in the Middle East, in Russia, Venezuela, Nigeria. That’s why I caution people from saying that I’m going to valuate something as a business because something’s going to happen in decades, versus something that might happen in the next two years that could really change the complexion of temporary prices or even change — in effect, Libya’s reserves have come out of the market for some period of time. And if they never get Humpty Dumpty back together again, then forever.

So that’s why I think it’s so very difficult as an investor to really know what to do. And that’s why to me, it’s really a risk management issue. How do I want to hedge my portfolio? Do I want to have some amount of upside from this commodity, because I think in the narrower window, there’s going to be good upside for the commodity? But then as I position my portfolio for the longer term, how do I protect myself from some of the risks that might come to play in the long run?

Stephen J. Brown: That’s interesting, because there were two questions from the audience related to exactly this point. Raise the issue of Russia and the negative interaction between energy risk and political risk, the sanctions on Russia and the effect that that’s going to have, not only on prices, but also on the possible reaction of Russia doing something strange in the Middle East. And that was raised as one of the questions here. What is your reaction to that?

Amy Myers Jaffe: Well, I think Putin has in the past made it very clear — I think that he’s taken a very aggressive strategy in Syria and that sometimes when the price of oil gets out of his comfort range, you see the Russians take a military response to something, I think, truly, in the hopes of getting the commodity price back up. So you really can’t rule that out.

But the flip side is, sometimes governments do things that are expedient and it’s not good for the long term. So by focusing so much on the geopolitical power of Russia in the short term, Vladimir Putin has devalued the natural gas assets under the ground in Russia. And because of what I’m saying, because the long-term pathway for how these reserves are going to get produced and who’s going to get them out of the ground first, if you really believe in that, if the Saudis are serious and we’re all thinking, it’s good to get the reserves out of the ground now, taking an action that means that investors exit your sector when you have very high-cost resources.

I mean, a lot of the Russian resources are Arctic. And I think that this whole question about the long-term future of reserves and the cost structure and the competition from low-cost producers — a lot of that means that Arctic resources are going to be a more risky investment than other kinds of resources. So the Russians have really shot themselves in the foot.

And I will tell you, I was at a conference before the Iranians signed the deal with the United States. And I had a frank conversation with some people who had the ear of the negotiating team in Iran. And I told them point blank that there’s a narrow window to get. If you have natural gas and you think you’re going to liquefy it into liquefied natural gas, LNG, and sell it to an India or get into the market in China, there’s a pretty competitive window.

And if you miss that window, if the Iranians had not gotten sanctions off themselves, so they’d spent 10 more years out of that market, they might have missed the window to get India’s demand forever. And the Russians are going to have that same problem in Europe and elsewhere. It’s very competitive in natural gas.

If someone is not under sanctions and not under geopolitical risk — the United States, one of the most interesting geopolitical actions that the Congress has taken, is allowing natural gas to be exported from the United States and allowing oil to be exported from the United States. Because natural gas producers that have low-cost production now in Pennsylvania or Ohio or down in Texas — there’s an LNG export terminal, could be an export terminal in the US East Coast. And there’s LNG exporting going on now from the US Gulf Coast. The United States producers could literally take Iran and Russia’s markets away from them and have the boom for themselves, because there’s no sanctions on them and they’re commercial and they have access to capital.

Stephen J. Brown: It’s really interesting. One person from the audience raised a fascinating question related to this. And we all thought that there was going to be the big crisis that was going to occur that would make it transparently obvious that we should have gone into green energy a long time before we did. And yet from what we understand from what you’re saying, that it would take some amazing crisis now to really — what would it take to make the case for green energy at this point in time?

Amy Myers Jaffe: Well, I love that question. It’s a fabulous question. It’s a really critical, key question. And here’s how I would answer it. First and foremost, if there was some kind of unbelievable political instability in Saudi Arabia or a war between Saudi Arabia and Iran, a real war, not a proxy war —

Stephen J. Brown: Or Russia.

Amy Myers Jaffe: Or Russia, which could happen. You can’t rule those kinds of things out. I think we’d see pretty quickly that losing that access to that production would be a pretty major impact in the market. But in terms of green investing, really the mistake that people made, even in the environmental movement, was they believed this oil story that the price of oil was going up to $200 and they didn’t have to be competitive with renewables, because oil’s going to be so expensive. It’s just going to make a market for green energy.

Well, the lesson is, the same technologies and knowledge and big data that the green energy folks were able to use to come up with these energy efficiency technologies and better batteries and better solar panels was the same stuff that the oil and gas industry was able to use to do shale. And that’s really the lesson. So the lesson is, green energy has to be competitive on its own account, with some assistance from government.

But my point to you is, it is competitive on its own account. And I think that really the mistake that people make is to count out as only this thing that needs to be quote, unquote, “subsidized.” And I get very frustrated in the United States. We have very, very politicized discussion in the United States.

But the bottom line is, everyone who drills for shale in the United States gets the intangible drilling credit. And that’s not that different than the credits that the solar industry gets. And the point is, in the United States, we’ve made the decision, which I think is the correct decision and I just explained to you why it’s important to US foreign policy — it’s a good decision to have to domestic energy in the United States.

And as we a society, whether that’s the global society or North America or just the United States and Canada, as we agree what our values are — and if our values are that we want to not be dependent on this volatile Middle East for our energy supply, and we can see how volatile it is, and we can see the benefits of using renewable energy even from the point of view of resilience.

They have this story people tell about a couple towns in New Jersey after Hurricane Sandy that used what we call community aggregation. In other words, they generated their own electricity from their own little municipal facilities. They were back on in a day. The rest of New Jersey was out for, like, a month. So I do think that these new networks and these new solutions with green energy are going to prove useful for a variety of different things, and not just because the price of oil is high. That’s really not the right way of looking at it.

Stephen J. Brown: Slightly related is, you put a lot of emphasis on shale oil, and that drew a lot of reactions from the audience. And there was some reaction — of course, shale oil has all kinds of environmental issues and environmental risks associated with it. And the question was, how economic is it really?

There is some question when one person asks, how do we really know how it can break even given the current price of oil? It seems pretty limited. How long will it take before shale oil ramps up outside North America?

What role does Saudi Arabia have? Is it possibly a conscious effort to make it uncompetitive, Saudi Arabia reducing the price of oil? Is that really to wipe shale oil out of the market? The question is, that people are asking is, is shale oil really a long-term solution to the energy shortage?

Amy Myers Jaffe: Let’s start with the last question first. Shale oil is not a long-term solution, because we know we need to be moving to cleaner energy. But we have over a billion liquid-fuel cars on the road in the world today. We have very few factories making cars that run on something else. And so we know we’re going to be using liquid fuel for a certain number of years, because the transition is going to take time.

So let’s start with that. But within that context, the cost structure for shale is falling. There are places where the shale is very productive. Take the Permian Basin in Texas as one key example. And in certain places in the Permian, people are producing the oil for $25 a barrel and $30 a barrel. If you talk to people about the whole swath of shale across the United States, people are saying you need $50 or $60 a barrel.

But I think those numbers truly are coming down. I think that people are making money. The problem the industry is having has to do with the lower valuation of their capitalization and the amount of money they can borrow against that. It’s not because they’re actually losing money producing the oil they’re producing.

Stephen J. Brown: It was raised by one of the —

Amy Myers Jaffe: Correct. And even on an infrastructure basis, the way fracking works is you can go back to someplace you produced 10 years ago. And you can re-frack in that same place and get oil and gas production with the same facilities you used to have. It’s very flexible. And it could be uneconomic today, and then the price of oil goes up 10 bucks. You can go right back to the same location and start fracking all over again.

So it’s not like a traditional reservoir where if you shut it in, it’s a big production to turn it back on. And maybe you’re going to lose pressure over time and you’re going to damage the field. It’s nothing like that. Like I said, it’s manufacturing. But there are a lot of risks. And it’s important that both as investors and as regulators, people understand those risks and that they work with only the top companies.

One of the good news about the shakeout is that hopefully, the companies with bad practices are the ones that are actually going to get shaken out of the industry because of the price downturn. So no question — if you don’t dispose of water properly from a shale production operation, you can definitely contaminate water.

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Ron Rimkus, CFA, is Director of Economics & Alternative Assets at CFA Institute, where he writes about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise:Alternative Investments · Economics

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